Should investors hedge their foreign currency exposure?

For global investors, one of the most important investment decisions is always whether to hedge currency exposure or not. This seems particularly relevant today given the sharp currency movements over the past two years. One way to address the decision is to consider currency hedging in three scenarios: in so-called “normal” conditions; in the current environment of “over active” central banks; and in situations where, over the long term, other countries take over the mantle of global leadership from the U.S.

1. Hedging in normal conditions

In “normal” market conditions, does it make sense for an investor to hedge currency exposure in fixed income and international equity markets? The right way to think of this is to consider the currency position in an international investment as an investment in its own right with a cost, an expected return and a contribution to overall portfolio volatility. If we assume that interest rates are the same in the domestic and international market then the cost of hedging is essentially zero; so this boils down to a question of expected return and impact on portfolio volatility. If we further assume that it is impossible to forecast which way the currency might move, then taking a foreign currency position is likely just adding to overall portfolio volatility while not providing any additional expected return. For this reason, many portfolio managers of developed country, high-quality bond portfolios prefer to hedge.

2. Hedging in a world of over-active central banks

Today, however, many investors believe there is a way to forecast currencies by recognizing the implications of further rounds of quantitative easing (QE) from Europe and Japan even as U.S. QE has come to an end. I believe that, while QE has succeeded in depressing long-term interest rates around the developed world, it has not stimulated economic growth.

In the case of Japan in 2013 and, more recently, in Europe, the prospect of QE has led to a welcome slide in their currencies. This can not only stave off concerns of deflation, but can also promote stronger export growth. Conversely, the U.S. central bank is being pushed by a tightening labor market into raising interest rates, likely starting in the middle of this year. This is also widely expected to put further downward pressure on currencies of many emerging markets. If these central banks stick to their playbooks, it is possible that the prospect of a further flood of euros and yen into the global market could push the U.S. dollar up further in 2015. If this was truly a very likely scenario, then investors might well want to not only hedge their currency exposure to international investments, but perhaps even over-hedge, allowing their portfolio to benefit from a rise in the dollar from these levels.

3. The long-term case for a balanced currency view

For long-term investors, however, it is not necessarily a great idea to avoid all foreign currency exposure in favor of the dollar. First, the dollar has already risen a great deal (see chart). The real effective exchange rate of the U.S. dollar, as calculated by the Federal Reserve, has risen 15% from its low of July 2011, and global measures of purchasing power suggest that it is now expensive relative to the yen and the euro.

Exhibit 1

In fact, for long-term investors, it is quite possible that the currency risk seen in international investments today will be seen as a currency opportunity in a few years time. It is important to consider the long-term challenges facing the U.S. economy, which is experiencing a slowdown in labor force participation and mediocre productivity. In addition, given its very late start on monetary tightening, there is a risk that the Federal Reserve will over-tighten too late in the cycle and then have to return to easing mode to try to rescue the U.S. economy from another recession. By contrast, the eurozone should see a pickup in growth this year but, starting with an unemployment rate of 11.4%, still has years of above-trend growth before it hits capacity constraints. Meanwhile, emerging markets are restrained by neither slow labor force growth nor weak productivity and could see strong growth even as the U.S. slows down. In this kind of scenario, the very forces which appear to be boosting the dollar today could be undermining it in two years.

It also is important to think about the reason for international diversification in the first place. U.S. investors often ask whether they need to invest in international companies at all since there are so many domestic companies with overseas operations. But the reason for international diversification is not just to increase your exposure to the rest of the world, but also to reduce your exposure to your home country in case of domestic economic disaster. A similar case can be made for foreign currency exposure. Today, the U.S. is leading the global expansion, attracting capital from around the world and seeing a sharp increase in its currency. However, if this story changes over time and other nations take up the mantle of global leadership, investors may well want to be fully exposed not just to their stocks and bonds, but also to their currencies.

Investment Implications

For long-term investors, it may make sense to forgo currency hedging if a secular slowdown in U.S. growth relative to the rest of the world allows both foreign currencies and foreign equity markets to outperform.

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